Common Cents

by Michael Harrington

  So, what is capital? Capital is any asset—money, land, tools, machinery, knowledge or skill—that is put to work in order to earn a positive return. We can categorize these various forms of capital as financial, physical, human, or social. The important point is that capital at work is capital invested. As such, capital is a crucial ingredient in the production of more goods and services, and yes, in the creation of more capital financially denominated as money. To illustrate the distinction between money and capital we can think of money as a reservoir of water. The water can sit there stagnant, slowly evaporating over time, or it can be fed into a series of irrigation canals, combining with fertilized soil to yield a crop of fruit. Idle money is merely a store of value, but money put to work is financial capital. Combining financial capital with labor, natural resources, and human ingenuity has yielded the vast material wealth of our modern world. Financial capital is an essential ingredient in the production process, and capital markets help to allocate and balance its supply and demand.

  The unique quality of financial capital differentiates it from other goods. Financial capital, like money, is only valued when it can be put to work to earn a return. Capital is invested with the anticipation that it will pay back in the form of future streams of income. The right to receive any future stream of income has a certain “capitalized” value called the fundamental or intrinsic value of capital. We see this most easily in debt instruments that specify the actual cash flows according to the debt contract. A mortgage or a bond are two obvious examples where the present value of future income streams is clearly specified. Other good examples are a utility stock that pays a high dividend, a life insurance annuity, or a house rental payment. A rental apartment has a certain fundamental value that directly relates to the rents paid by the tenant.

  As the future is unpredictable, the perceived value of these future income streams can vary considerably. The stream of payments from a Treasury bond with the bond principal amount backed by the U.S. government is considered the most secure of financial assets, so its value is more easily ascertained and relatively stable. Other asset streams, such as high yield corporate bonds (aka junk bonds), are much less secure and their bond values can fluctuate widely. Ownership of stock, such as a share of IBM, secures the right to a share of future earnings that may or may not be realized, depending on the success of the business.

  As financial asset valuations become more exposed to uncertainty and risk, more of the value is subject to the capricious confidence or uncertainty of market buyers and sellers, and less related to the asset’s more stable fundamental value. I may think Ford Motor Company has a bright future, while you believe its prospects look bleak. If some event changes prevailing market opinions one way or the other, the price of Ford stock and its valuation will adjust abruptly. The value of risky capital is thus determined largely by public opinion and is expressed in capital markets that can fluctuate widely from day to day. We will call this the tradable value of capital to distinguish it from the fundamental value explained above. The price volatility of capital represents an inherent risk because capital value based on emotion can evaporate in an instant. We have all heard the stories of Internet stocks that shot to unrealistic price levels, only to see that valuation vanish completely, and almost immediately, when the euphoric bubble popped. Another way of understanding this is that the value of a financial asset only becomes real when you get that future income flow in your hand.

  This subjective, or tradable, value of capital also means that, rather than merely employing capital in production, capital gains and losses can be realized by market traders as valuations fluctuate in price. We all know that perennial investment advice to "buy low and sell high." But for every asset bought at a low price, there was a seller, and for every one sold at a high price there was a buyer. So, trading value is in the eye of the beholder. This causes traders in financial assets to trade based on what they think others will think. This becomes a psychological game: I will try to trade by anticipating what you are thinking of doing, and will do my best to influence what you do. The gaming of financial markets creates considerable white noise and uncertainty in the investment world surrounding the valuation of capital. But the problem gets worse.

  The demand for financial assets leads to increased prices for those assets. This increased value can then be capitalized into credit that can be used to buy more financial assets. (Like rising housing prices were used to create more lending credit in order to buy more houses and other goods.) The access to credit leverages and amplifies an asset bubble by raising prices of the assets, generating more credit, raising prices again, and so on in a positive feedback loop.

  This market process of positive feedback driven by emotion and credit creation is what makes financial markets volatile and unstable. The tradable value of capital thrives on the momentum of emotion that, with credit leverage, can become highly inflated due to what our central bankers have called "irrational exuberance." One economist has referred to the tradable value as the confidence value of capital.[27] As confidence in the future increases, the value of capital increases because it can be put to work to create additional wealth. There is a problem, however, in distinguishing justified confidence from false confidence. Most economists agree that asset prices that depart too much from fundamental values are an indication of false confidence (aka "pie-in-the-sky" wishful thinking). The tricky part is knowing when they have reached that level.

  We can see that financial markets behave very differently from goods markets. For instance, I don’t buy a pair of shoes by trying to figure out whether you will pay the same amount, more, or less. I merely decide what the shoes are worth to me and either buy them or not. In goods markets, when the price of a product rises, demand for it goes down, as buyers perceive the price as too rich. When the price of a television doubles, consumer demand for that television falls and the excess inventory forces the producer or retailer to lower the price to the equilibrium point, perhaps with an “inventory sale.” As a result of this negative feedback process, supply and demand return to equilibrium. As financial assets increase in price, however, they often become more desirable. As demand increases, financial asset prices rise even higher, away from an equilibrium based on fundamental values. This positive feedback process generates a form of herd behavior. As the train is seen leaving the station, investors fear they're missing it and jump on, driving prices into the stratosphere.

  As we've observed this phenomenon again and again throughout the history of financial crises, we know only too well what happens next.[28] The tradable value of capital follows what we might call the "bigger fool" theory of investment. An investor overpays for a financial asset in the hope that some “bigger fool” will then buy it from him at an even higher price. There are only so many fools with money to lose in this world. Something always triggers the return of rationality (usually, the easy credit that is fueling such mania dries up) and everyone heads for the exit at once, causing prices to collapse and the bubble to burst. We will discuss the recent housing bubble later, but is this not exactly what happened when we turned houses into get-rich-quick, tradable, financial assets instead of homes? As prices rose, people clamored to jump on board the train before it left the station, driving prices to extraordinary heights. Soon, houses were being bought simply to be “flipped” at a higher price, just like a penny stock. There was even a television show called “Flip This House.” Everybody was betting on there being a bigger fool to sell to. There was little relation between home prices and the fundamental values indicated by the incomes of buyers or rental prices of comparable housing.

  We can think of capital as the embodiment of confidence in the future and value it accordingly. Uncertainty is another concept that is hard to pin down and measure, though we know it when we feel it.[29] It is the opposite of confidence, or “irrational exuberance.” When uncertainty increases, the value of capital decreases as the present becomes valued more highly relative to the future
. If we knew the world was to end tomorrow, the value of all capital would plunge to zero because it would have no useful value to you over the next 24 hours. Likewise, if we knew we would live forever, capital would be highly valued and in high demand because we would be mindful of what we needed for the future, assured there would be a future, and would save and invest accordingly. This logic explains how the investment banking firm of Bear Stearns could see its capital worth literally evaporate into thin air. As of November 2006, the company had total capital of approximately $66.7 billion and total assets of $350.4 billion. Less than sixteen months later, JP Morgan Chase offered $236 million for the entire firm (later the bid was raised to $1.1 billion). This was a loss of confidence on an epic scale and for Bear Stearns there was no tomorrow.

  2.5 Labor and the Problem of Unemployment

  Labor utilization and the recurring problem of unemployment have been the major preoccupations of economists since the Great Depression. There are reasons for this that go beyond sympathy for the unemployed. Labor and capital are the primary ingredients to creating wealth. If we have 10% unemployment, then the nation is under producing by at least 10% or more. This adds up to a lot of national income and wealth creation that is lost forever. Of course, since the production process employs both labor and capital, unemployment also means idle capital or capital misallocated toward other, less productive uses, like asset speculation. Full employment and full capacity utilization of available capital has been a primary policy objective for obvious political and economic reasons.

  Theories of employment are quite complex and sophisticated, but to simplify them let's refer back to our pie-baking example. Let’s assume we have unemployed chefs. One policy solution is to increase the use of capital in combination with more chefs to create more pies. We might encourage this capital utilization by seeking to increase the demand for pies by providing a government subsidy for buying pies (food stamps?). Our solution seems simple: More pie eating leads to higher prices for pies, attracting more capital investment in pie production, which leads to more chefs becoming employed, causing the population to grow fatter and happier. The problem is that the original unemployment may have resulted from some basic behaviors associated with human labor. One is that the price of labor is less flexible than the prices of other goods. If the unemployment is created because wages are too high, the wage will not fall back down to an equilibrium level to realize full employment. Why? Because loss aversion means we are very resistant to reducing our wage incomes. We call this wage rigidity. If wage rigidity is the cause of the original unemployment, trying to artificially stimulate the demand for pies to employ more chefs at the prevailing wage is the wrong policy because it is unsustainable. The government subsidies will need to go on forever, and it might be more economical just to give the subsidies directly to the unemployed chefs to retrain for another job. In our example, if there are too many unemployed chefs, perhaps chefs are commanding salaries that are too high given the demand for pies and the revenues of the bakery. But how do we get a chef to reduce his/her wage or perceived value? Unfortunately, this can usually be achieved only through layoffs and unemployment, which is the problem we were seeking a solution for in the first place. This conundrum is evidence of a market failure.

  Another problem with unemployment is that it is difficult for available labor to find the proper match with capital. There are considerable search costs and mobility problems for job and career changes. If one lives in California and the baking jobs are in Texas or Florida, it is quite costly to pack up the family and move. (The housing crisis we engineered over the past decade will only further increase this relative immobility and misallocation of labor, as people cannot afford to absorb large losses on the sales of their existing homes.) So, the impediment of search costs represents another potential labor market failure.

  The policy problem we face is how to overcome these market failures and match up capital with labor to increase production. It is not a simple task and is fraught with intellectual controversy.

  2.6 Competing Macroeconomic Theories

  There are several competing schools of thought on macroeconomic policy, each with various offshoots. We shall discuss the two most dominant ones: the Keynesian and Classical schools. Both theoretical approaches must choose from the same selection of fiscal and monetary policy tools, which have traditionally focused on the interest rate, taxes, and government spending. Recently, the monetary authorities have introduced some new policy tools that encompass direct loans, guarantees, and asset purchases (the infamous bailouts and 'quantitative easing" QE1, QE2, etc. – all of these basically increase liquidity, i.e. inject cash, into the banking system to shore up the financial sector of the economy.)

  We'll begin our discussion with the interest rate, since that is fundamental to our market model. As we've discussed, economic decisions over time are guided by the interest rate, which helps to balance the supply and demand for capital and to balance consumption and savings over time. During a growth cycle, when confidence in the future is high, interest rates will rise and present consumption will be deferred as investment is increased. Savings will rise to supply credit for additional investment demand as opportunities warrant. Production increases. In boom times we borrow from future consumption, confident that we will have greater income in the future to pay loans back without reducing future consumption. In short, the pie is growing; so all the pieces get bigger. Most recently, this scenario unfolded in the U.S. during the 1990s technology boom.

  On the downside, when the future becomes more uncertain, the value of capital falls and interest rates decline. The pie is now shrinking as income, consumption, and savings all decline. The desire to save increases due to uncertainty, but low interest rates do not adequately increase present consumption demand or new investment. As production declines, the lack of investment demand will keep interest rates low and borrowing will likely be channeled into bidding up real asset or commodity prices. The resulting asset bubbles foreshadow the contraction phase of the economic cycle, which then causes these same asset prices to collapse. We have been experiencing this phase of the economic cycle off and on since 2001. The Zero Interest Rate Policy (ZIRP) the Fed has conducted since the 2008 financial crisis is reflected in the low interest on savings, sputtering demand, and increases in commodity prices such as food and energy.

  In our model the interest rate is a price signal that reflects the overall desire to consume or save, and the incentives to invest and produce. The interest rate will reflect economic fundamentals, such as technology cycles and demographics, and also the short term effects of policy and financial market confidence or uncertainty. Because of its critical role in the allocation of capital, the interest rate is the most important price to get right. Fortunately, or perhaps unfortunately, the interest rate is also the most accessible tool the Federal Reserve can manipulate to affect the economy.[30]

  As we have shown with our simple model and the discussion of capital and labor markets, the macroeconomy can become unstable due to human nature and the dynamics of financial markets. During a growth cycle, the feedback from financial markets tends to encourage overinvestment relative to present and future consumption. The result is too much capital chasing fewer and fewer productive investments, until the investments eventually result in negative, rather than positive, returns. The decline in the value of capital leads to an economic contraction, or what we would commonly call a recession or depression.

  After the Great Depression of the 1930s, policymakers under the influence of the renowned economist John Maynard Keynes began to recognize the problem of inadequate private consumption demand over time. Inadequate consumption leads to less investment and lower production, which, in a vicious cycle, lead to even less consumption demand. Fiscal policies were formulated to stimulate demand, leading to government spending that supplemented the private economy. These programs included temporary measures, such as the Works Progress Administration under the New Deal, and
more lasting ones such as national unemployment insurance and Social Security. Under certain conditions, such government spending can work very well. However, one of the problems that arises when the economy gets off-track is that price signals get distorted. Government stimulus can often perpetuate, if not exacerbate, these price distortions, sending more wrong market signals and reducing efficiency.

  In response, Classical theorists, or market fundamentalists, argue that getting prices right and reallocating resources, especially capital and labor, is essential to righting the economy and getting it back on a growth path. Politically motivated government spending is likely to only make matters worse. But a correction of distorted market prices often means certain asset prices and certain labor costs must adjust downward. This implies business losses and rising unemployment, which are usually politically untenable. There is no clean reconciliation of these two approaches. It is more a matter of which approach one chooses to favor under any given economic circumstance.

  The primary fiscal tools available to policymakers are tax policy and public spending programs. Classicalists favor cutting taxes to encourage private sector investment and reducing the dead-weight costs of public sector spending, while Keynesians favor increased government spending and public investment to stimulate present consumption and production. The tug of war between these competing visions, over the last three decades especially, has given us tax cuts plus spending increases, with the result that the gap between them is funded by an exploding level of public debt. This has landed us where we are now. Our focus should not be on the level of debt as much as on measuring what this debt accumulation is doing for us – is it making us more productive and richer, or less so?